Exam 9: Applying Financial Models to Value, structure, and Negotiate Mergers and Acquisitions

A standalone business is one whose financial statements reflect all the costs of running the business and all of the revenues generated by the business.

Case Study Short Essay Examination Questions Tribune Company Acquires the Times Mirror Corporation in a Tale of Corporate Intrigue Background: Oh, What Tangled Webs We Weave. . . CEO Mark Willes had reason to be optimistic about the future. Operating profits had grown at a double-digit rate, and earnings per share had grown at a 55% annual rate between 1995 to 1999. Many shareholders appeared to be satisfied. However, some were not. Although pleased with the improvement in profitability, they were concerned about the long-term growth prospects of the firm. Reflecting this disenchantment, Times Mirror's largest shareholder, the Chandler family, was contemplating the sale of the company and along with it the crown jewel Los Angeles Times. It had been assumed for years that the Chandler family trusts made a sale of Times Mirror out of the question. The Chandler's super voting stock (i.e., stock with multiple voting rights) allowed them to exert a disproportionate influence on corporate decisions. The Chandler Trusts controlled more than two-thirds of voting shares, although the family owned only about 28% of the total shares of the outstanding stock. In May 1999 the Tribune Chairman John Madigan contacted Willes and made an offer for the company, but Willes, with the help of his then-chief financial officer (CFO), Thomas Unterman, made it clear to Madigan that the company was not for sale. What Willes did not realize was that Unterman soon would be serving in a dual role as CFO and financial adviser to the Chandlers and that he would eventually step down from his position at Times Mirror to work directly for the family. In his dual role, he worked without Willes' knowledge to structure the deal with the Tribune. Following months of secret negotiations, the Chicago-based Tribune Company and the Times Mirror Corporation announced a merger of the two companies in a cash and stock deal valued at approximately $7.2 billion, including $5.7 billion in equity and $1.5 billion in assumed debt. The transaction, announced March 13, 2000, created a media giant that has national reach and a major presence in 18 of the nation's top 30 U.S. markets, including New York, Los Angeles, and Chicago. The combined company has 22 television stations, four radio stations, and 11 daily newspapers-including the Los Angeles Times, the nation's largest metropolitan daily newspaper and flagship of the Times Mirror chain. Transaction Terms: Tribune Shareholders Get Choice of Cash or Stock The Tribune agreed to buy 48% of the outstanding Times Mirror stock, about 28 million shares, through a tender offer. After completion of the tender offer, each remaining Times Mirror share would be exchanged for 2.5 shares of Tribune stock. Under the terms of the transaction, Times Mirror shareholders could elect to receive $95 in cash or 2.5 shares of Tribune common stock in exchange for each share of Times Mirror stock. Holders of 27.2 million shares of Times Mirror stock elected to receive Tribune stock, whereas holders of 10.6 million elected to receive cash. Because the amount of cash offered in the merger was limited and the cash election was oversubscribed, Times Mirror shareholders electing to receive cash actually received a combination of cash and stock on a pro rata basis (Table 1). Newspaper Advertising Revenues Continue to Shrink Most U.S. newspapers are mired in the mature or declining phase of their product life cycle. For the past half-century, newspapers have watched their portion of the advertising market shrink because of increased competition from radio and television. By the early 1990s, all major media began taking a significant hit in their advertising revenue streams as businesses discovered that direct mail could target their message more precisely. Moreover, consolidation among major retailers further reduced the size of advertising dollar pool. The same has happened with numerous large supermarket chain mergers. Newspaper advertising revenues also have been threatened by increasing competition from advertising and editorial content delivered on the internet. Finally, newspapers simply have become less attractive places to advertise as readership continues to decline as a result of an aging population and new generations that do not see newspapers as relevant. Times Mirror: A Largely Traditional Business Model As essentially a traditional newspaper, Times Mirror publishes five metropolitan and two suburban daily newspapers, a variety of magazines, and professional information such as flight maps for commercial airline pilots. The Los Angeles Times, a southern California institution founded in 1881, is Times Mirror's largest holding and operates some two dozen expensive foreign news bureaus-more than any other newspaper in the country. The Los Angeles Times has more than 1200 Los Angeles Times reporters and editors around the world (CNNfn, March 13, 2000). Tribune Company Profile: The Face of New Media? Unlike the Times Mirror, Tribune has built its strategy around four business groups: broadcasting, publishing, education, and interactive. The Tribune is also an equity investor in America Online and other leading internet companies, underscoring the company's commitment to new-media technologies. Applying leading edge new-media technology has allowed the Tribune to transform they way it does business, and the technology commitment creates the opportunity for future growth. The internet has been the greatest driver for change, and the Tribune's interactive business group continues to focus on capitalizing on emerging Web technologies. Throughout the company, new technologies have been applied aggressively to create new products, improve existing products, and make operations more efficient. The Tribune's non-newspaper revenues accounted for more than half of its earnings by 2000. Anticipated Synergy Cost Savings: Opportunities Abound Cost savings are expected because of the closing of selected foreign and domestic news bureaus, a reduction in the cost of newsprint through greater volume purchases, the closing of the Times Mirror corporate headquarters, and elimination of corporate staff. Such savings are expected to reach $200 million per year (Table 2). Revenue: Great Potential . . . But Is It Achievable? The combined companies will have a major presence in 18 of the nation's top 30 U.S. advertising markets, including New York, Los Angeles, and Chicago. The combined companies provide unprecedented opportunities for advertisers to reach major market consumers in any media form-broadcast, newspapers, or interactive. In addition, the combined companies will benefit consumers by giving them rich and diverse choices for obtaining the news, information, and entertainment they want anytime, anywhere. These factors provide an increased ability to capture national advertising in the most important U.S. population centers. The significantly greater breadth of the combined firm's geographic coverage is expected to boost advertising revenues from about 3% to 6% annually. Integration Challenges: Cultural Warfare? Based on the current, traditional culture found at the Los Angeles Times and other Times Mirror properties, integration following the merger was likely to be slow and painful. Concerns among journalists about spreading their talents thin across three or four media-print, television, online, and radio-in the course of a day's work raised the stress level. Although the Tribune has been able to make the transition to a largely multimedia company more rapidly than the more traditional newspapers, it has been costly. For example, development losses in 1999 were $30-35 million at Chicagotribune.com and an estimated $45 million in 2000. The bleeding was expected to continue for some time and to constitute a major distraction for the management of the new company. Financial Analysis The present values of the Tribune, Times Mirror, and the combined firms are $8.5 billion, $2.4 billion, and $16.5 billion, respectively; the estimated present value of synergy is $5.6 billion (Table 3). This assumes that pretax cost savings are phased in as follows: $25 million in 2000, $100 million in 2001, and $200 million thereafter. The cost savings are net of all expenses related to realizing such savings such as severance, lease buyouts, and legal fees. Table 4 describes how the initial offer price could have been determined and the postmerger distribution of ownership between Times Mirror and Tribune shareholders. Epilogue Only time will tell if actual returns to shareholders in the combined Tribune and Times Mirror company exceed the expected financial returns provided in the valuation models in this case study. Times Mirror shareholders earned a substantial 102% purchase price premium over the value of their shares on the day the merger was announced. Some portion of those undoubtedly "cashed out" of their investment following receipt of the new Tribune shares. However, for those former Times Mirror shareholders continuing to hold their Tribune stock and for Tribune shareholders of record on the day the transaction closed, it is unclear if the transaction made good economic sense. Discussion Questions: -In your judgment,did it make good strategic sense to combine the Tribune and Times Mirror corporations? Why? / Why not?

Examples of relevant historical relationships that are useful for forecasting cash flows include the relationship between fixed and variable expenses,and the impact on revenue of changes in product prices and unit sales.If these relationships can reasonably be expected to continue through the forecast period,they can be used to project the earnings and cash flows used in the valuation process.However,it is important to ignore cyclical movements in the data.

Which of the following is not true about generally accepted accounting principles (GAAP)?

Potential sources of value rarely include factors not recorded on a firm's balance sheet.

In calculating the value of net synergy,the costs required to realize the anticipated synergy should be ignored because they are difficult to forecast.

While it is legitimate for a firm to follow different accounting practices for financial reporting and tax purposes,the relationship between book and tax accounting is likely to remain constant over time,unless there are changes in tax rules or accounting standards.

If the target firm's ratio of bad debt reserves as a percent of projected revenue is increasing,the analyst can be confident that the firm is boosting revenue by not reserving enough to cover probable future losses.

A clear statement of all assumptions underlying the model's projections forces the analyst to display their biases and to be prepared to defend their assumptions to others.

Case Study Short Essay Examination Questions Ford Acquires Volvo's Passenger Car Operations This case illustrates how the dynamically changing worldwide automotive market is spurring a move toward consolidation among automotive manufacturers. The Volvo financials used in the valuation are for illustration only- they include revenue and costs for all of the firm's product lines. For purposes of exposition, we shall assume that Ford's acquisition strategy with respect to Volvo was to acquire all of Volvo's operations and later to divest all but the passenger car and possibly the truck operations. Note that synergy in this business case is determined by valuing projected cash flows generated by combining the Ford and Volvo businesses rather than by subtracting the standalone values for the Ford and Volvo passenger car operations from their combined value including the effects of synergy. This was done because of the difficulty in obtaining sufficient data on the Ford passenger car operations. Background By the late 1990s, excess global automotive production capacity totaled 20 million vehicles, and three-fourths of the auto manufacturers worldwide were losing money. Consumers continued to demand more technological innovations, while expecting to pay lower prices. Continuing mandates from regulators for new, cleaner engines and more safety measures added to manufacturing costs. With the cost of designing a new car estimated at $1.5 billion to $3 billion, companies were finding mergers and joint ventures an attractive means to distribute risk and maintain market share in this highly competitive environment. By acquiring Volvo, Ford hoped to expand its 10% worldwide market share with a broader line of near-luxury Volvo sedans and station wagons as well as to strengthen its presence in Europe. Ford saw Volvo as a means of improving its product weaknesses, expanding distribution channels, entering new markets, reducing development and vehicle production costs, and capturing premiums from niche markets. Volvo Cars is now part of Ford's Premier Automotive Group, which also includes Aston Martin, Jaguar, and Lincoln. Between 1987 and 1998, Volvo posted operating profits amounting to 3.7% of sales. Excluding the passenger car group, operating margins would have been 5.3%. To stay competitive, Volvo would have to introduce a variety of new passenger cars over the next decade. Volvo viewed the capital expenditures required to develop new cars as overwhelming for a company its size. Historical and Projected Data The initial review of Volvo's historical data suggests that cash flow is highly volatile. However, by removing nonrecurring events, it is apparent that Volvo's cash flow is steadily trending downward from its high in 1997. Table 9-10 displays a common-sized, normalized income statement, balance sheet, and cash-flow statement for Volvo, including both the historical period from 1993 through 1999 and a forecast period from 2000 through 2004. Although Volvo has managed to stabilize its cost of goods sold as a percentage of net sales, operating expenses as a percentage of net revenue have escalated in recent years. Operating margins have been declining since 1996. To regain market share in the passenger car market, Volvo would have to increase substantially its capital outlays. The primary reason valuation cash flow turns negative by 2004 is the sharp increase in capital outlays during the forecast period. Ford's acquisition of Volvo will enable volume discounts from vendors, reduced development costs as a result of platform sharing, access to wider distribution networks, and increased penetration in selected market niches because of the Volvo brand name. Savings from synergies are phased in slowly over time, and they will not be fully realized until 2004. There is no attempt to quantify the increased cash flow that might result from increased market penetration. PAGE 15 PAGE 19 Determining the Initial Offer Price Volvo's estimated value on a standalone basis is $15 billion. The present value of anticipated synergy is $1.1 billion, suggesting that the purchase price for Volvo should lie within a range of $15 million to about $16 billion. Although potential synergies appear to be substantial, savings due to synergies will be phased in gradually between 2000 and 2004. The absence of other current bidders for the entire company and Volvo's urgent need to fund future capital expenditures in the passenger car business enabled Ford to set the initial offer price at the lower end of the range. Thus, the initial offer price could be conservatively set at about $15.25 billion, reflecting only about one-fourth of the total potential synergy resulting from combining the two businesses. Other valuation methodologies tended to confirm this purchase price estimate. The market value of Volvo was $11.9 billion on January 29, 1999. To gain a controlling interest, Ford had to pay a premium to the market value on January 29, 1999. Applying the 26% premium Ford paid for Jaguar, the estimated purchase price including the premium is $15 billion, or $34 per share. This compares to $34.50 per share estimated by dividing the initial offer price of $15.25 billion by Volvo's total common shares outstanding of 442 million. Determining the Appropriate Financing Structure Ford had $23 billion in cash and marketable securities on hand at the end of 1998 (Naughton, 1999). This amount of cash is well in excess of its normal cash operating requirements. The opportunity cost associated with this excess cash is equal to Ford's cost of capital, which is estimated to be 11.5%-about three times the prevailing interest on short-term marketable securities at that time. By reinvesting some portion of these excess balances to acquire Volvo, Ford would be adding to shareholder value, because the expected return, including the effects of synergy, exceeds the cost of capital. Moreover, by using this excess cash, Ford also is making itself less attractive as a potential acquisition target. The acquisition is expected to increase Ford's EPS. The loss of interest earnings on the excess cash balances would be more than offset by the addition of Volvo's pretax earnings. Epilogue Seven months after the megamerger between Chrysler and Daimler-Benz in 1998, Ford Motor Company announced that it was acquiring only Volvo's passenger-car operations. Ford acquired Volvo's passenger car operations on March 29, 1999, for $6.45 billion. At $16,000 per production unit, Ford's offer price was considered generous when compared with the $13,400 per vehicle that Daimler-Benz AG paid for Chrysler Corporation in 1998. The sale of the passenger car business allows Volvo to concentrate fully on its truck, bus, construction equipment, marine engine, and aerospace equipment businesses. (Note that the standalone value of Volvo in the case was estimated to be $15 billion. This included Volvo's trucking operations.) and Answers: -How was the initial offer price determined according to this case study? Do you find the logic underlying the initial offer price compelling? Explain your answer.

Realizing synergy often requires spending money.Which of the following are examples of such expenditures?

A merger which is expected to produce synergy

Minimum purchase price or initial offer price for a target is the target's standalone value or market value.

Case Study Short Essay Examination Questions Ford Acquires Volvo's Passenger Car Operations This case illustrates how the dynamically changing worldwide automotive market is spurring a move toward consolidation among automotive manufacturers. The Volvo financials used in the valuation are for illustration only- they include revenue and costs for all of the firm's product lines. For purposes of exposition, we shall assume that Ford's acquisition strategy with respect to Volvo was to acquire all of Volvo's operations and later to divest all but the passenger car and possibly the truck operations. Note that synergy in this business case is determined by valuing projected cash flows generated by combining the Ford and Volvo businesses rather than by subtracting the standalone values for the Ford and Volvo passenger car operations from their combined value including the effects of synergy. This was done because of the difficulty in obtaining sufficient data on the Ford passenger car operations. Background By the late 1990s, excess global automotive production capacity totaled 20 million vehicles, and three-fourths of the auto manufacturers worldwide were losing money. Consumers continued to demand more technological innovations, while expecting to pay lower prices. Continuing mandates from regulators for new, cleaner engines and more safety measures added to manufacturing costs. With the cost of designing a new car estimated at $1.5 billion to $3 billion, companies were finding mergers and joint ventures an attractive means to distribute risk and maintain market share in this highly competitive environment. By acquiring Volvo, Ford hoped to expand its 10% worldwide market share with a broader line of near-luxury Volvo sedans and station wagons as well as to strengthen its presence in Europe. Ford saw Volvo as a means of improving its product weaknesses, expanding distribution channels, entering new markets, reducing development and vehicle production costs, and capturing premiums from niche markets. Volvo Cars is now part of Ford's Premier Automotive Group, which also includes Aston Martin, Jaguar, and Lincoln. Between 1987 and 1998, Volvo posted operating profits amounting to 3.7% of sales. Excluding the passenger car group, operating margins would have been 5.3%. To stay competitive, Volvo would have to introduce a variety of new passenger cars over the next decade. Volvo viewed the capital expenditures required to develop new cars as overwhelming for a company its size. Historical and Projected Data The initial review of Volvo's historical data suggests that cash flow is highly volatile. However, by removing nonrecurring events, it is apparent that Volvo's cash flow is steadily trending downward from its high in 1997. Table 9-10 displays a common-sized, normalized income statement, balance sheet, and cash-flow statement for Volvo, including both the historical period from 1993 through 1999 and a forecast period from 2000 through 2004. Although Volvo has managed to stabilize its cost of goods sold as a percentage of net sales, operating expenses as a percentage of net revenue have escalated in recent years. Operating margins have been declining since 1996. To regain market share in the passenger car market, Volvo would have to increase substantially its capital outlays. The primary reason valuation cash flow turns negative by 2004 is the sharp increase in capital outlays during the forecast period. Ford's acquisition of Volvo will enable volume discounts from vendors, reduced development costs as a result of platform sharing, access to wider distribution networks, and increased penetration in selected market niches because of the Volvo brand name. Savings from synergies are phased in slowly over time, and they will not be fully realized until 2004. There is no attempt to quantify the increased cash flow that might result from increased market penetration. PAGE 15 PAGE 19 Determining the Initial Offer Price Volvo's estimated value on a standalone basis is $15 billion. The present value of anticipated synergy is $1.1 billion, suggesting that the purchase price for Volvo should lie within a range of $15 million to about $16 billion. Although potential synergies appear to be substantial, savings due to synergies will be phased in gradually between 2000 and 2004. The absence of other current bidders for the entire company and Volvo's urgent need to fund future capital expenditures in the passenger car business enabled Ford to set the initial offer price at the lower end of the range. Thus, the initial offer price could be conservatively set at about $15.25 billion, reflecting only about one-fourth of the total potential synergy resulting from combining the two businesses. Other valuation methodologies tended to confirm this purchase price estimate. The market value of Volvo was $11.9 billion on January 29, 1999. To gain a controlling interest, Ford had to pay a premium to the market value on January 29, 1999. Applying the 26% premium Ford paid for Jaguar, the estimated purchase price including the premium is $15 billion, or $34 per share. This compares to $34.50 per share estimated by dividing the initial offer price of $15.25 billion by Volvo's total common shares outstanding of 442 million. Determining the Appropriate Financing Structure Ford had $23 billion in cash and marketable securities on hand at the end of 1998 (Naughton, 1999). This amount of cash is well in excess of its normal cash operating requirements. The opportunity cost associated with this excess cash is equal to Ford's cost of capital, which is estimated to be 11.5%-about three times the prevailing interest on short-term marketable securities at that time. By reinvesting some portion of these excess balances to acquire Volvo, Ford would be adding to shareholder value, because the expected return, including the effects of synergy, exceeds the cost of capital. Moreover, by using this excess cash, Ford also is making itself less attractive as a potential acquisition target. The acquisition is expected to increase Ford's EPS. The loss of interest earnings on the excess cash balances would be more than offset by the addition of Volvo's pretax earnings. Epilogue Seven months after the megamerger between Chrysler and Daimler-Benz in 1998, Ford Motor Company announced that it was acquiring only Volvo's passenger-car operations. Ford acquired Volvo's passenger car operations on March 29, 1999, for $6.45 billion. At $16,000 per production unit, Ford's offer price was considered generous when compared with the $13,400 per vehicle that Daimler-Benz AG paid for Chrysler Corporation in 1998. The sale of the passenger car business allows Volvo to concentrate fully on its truck, bus, construction equipment, marine engine, and aerospace equipment businesses. (Note that the standalone value of Volvo in the case was estimated to be $15 billion. This included Volvo's trucking operations.) and Answers: -What was the composition of the purchase price? Why was this composition selected according to this case study?

Which of the following is not true about common size financial statements?

Target is a wholly owned subsidiary of MegaCorp Inc.MegaCorp supplies a number of services to target.Target sells some of its products to other MegaCorp subsidiaries.Target also buys products from other MegaCorp subsidiaries that are used as inputs in producing Target's products.Which of the following adjustments should the acquirer make to Target's financial statements before valuing the firm?

A target firm's high employee turnover is often considered a destroyer of value.

When one company acquires another,year over year historical earnings comparisons for the acquiring firm are unaffected.

Financial models are of little value in determining whether the proposed purchase price can be financed by the acquirer.

The maximum purchase price is the minimum price plus the present value of sources of value.True or False